When Rates Fall, You Save
Lower mortgage rates can save you thousands of dollars over the life of a loan. For home buyers, lower mortgage rates can also increase your buying power. Without a doubt, anyone who wants to buy or refinance a home needs to consider how mortgage rates will affect your loan.
So how much is a big increase or decrease? When the news reports a 1/2 point drop in rates, is that a big deal? Most importantly, does it make sense to wait for a lower rate, before locking in a loan?
This article explains:
- For Home Buyers: How do lower mortgage rates affect my purchasing power?
- For Homeowners: When does it make financial sense to refinance my existing mortgage?
How Lower Mortgage Rates Boost Purchasing Power
Lower mortgage rates can boost your purchasing power in two ways. First, a lower rate will lower your interest payment. Secondly, when rates are lower, lenders may waive monthly mortgage insurance, in exchange for a slightly higher rate.
Lower Rates = Lower Payments
When your lender qualifies you to buy a home, the purchase approval amount is based on a total monthly housing payment. (More on the mortgage affordability calculation here.)
Indeed, a big chunk of that monthly payment is mortgage interest. So, the lower your mortgage interest rate, the more home you can afford.
Here’s example of the difference one percentage point can make:
$600,000 loan @ 6.75% interest = monthly principal & interest payment of $3,892
$600,000 loan @ 5.75% interest = monthly principal & interest payment of $3,501
For a $600,000 loan, a reduction of just one percentage point will lower monthly payments by almost $400.
Next, let’s say your lender qualifies you for a total monthly payment of $5000. When buying a home in San Diego County with no HOA fee and 20% down payment, see the difference in your maximum purchase price:
6.75% Interest Rate: $785,000 maximum purchase price
Principal & Interest: $4,073
Property Taxes & Homeowners Insurance: $927
Total Monthly Payment: $5,000
5.75% Interest Rate: $855,000 maximum purchase price
Principal & Interest: $3,992
Property Taxes & Homeowners Insurance: $1,008
Total Monthly Payment: $5,000
This estimate shows that a reduction of one percentage point increases purchasing power by $80,000.
Lender-Paid Mortgage Insurance
Mortgage insurance is usually required when you put down less than 20% of the purchase price. When rates are low, lenders may offer lender paid mortgage insurance (LPMI) on conventional loans. Instead of paying monthly mortgage insurance, you pay a slightly higher interest rate. LPMI is usually available to borrowers with excellent credit scores.
For borrowers with less than 20% down and excellent FICO scores, LPMI programs may be a good option, especially when interest rates are low.
When to Refinance an Existing Mortgage
Even though lenders are always inviting us to refinance, it often doesn’t make financial sense. Slightly lower mortgage rates may not save you money in the long run.
I don’t recommend refinancing unless you’re going to save money both short-term, and long-term. Here’s my list of criteria that I use for both myself and my clients:
- There needs to be a lender credit that covers all closing costs, and
- My monthly payment needs to drop by at least $150/month.
Lender Credits
When lenders offer mortgage rates, you often have the option to take a slightly higher rate in exchange for a credit. (Conversely, you can also “buy down” the rate, by paying a fee for a lower rate.) Lender credits are usually available for conventional loans, as well as FHA and VA loans.
Most importantly, compare the credit with the increase in monthly interest payment. Does it make sense, for example, to take a $3500 credit in exchange for paying an additional $35/month in interest? Since it would take 100 months of payments (over 8 years) to accumulate $3500, most borrowers would agree to the credit.
Refinances cost approximately $3500 in one-time costs, so check if you can receive a lender credit high enough to cover most, if not all, one-time costs, in exchange for a rate that’s still low enough to lower your monthly payment.
Read more about refinancing closing costs here.
Lower Monthly Payment
When you refinance, you usually lock in a new 30-year loan. So if you have 27 years left in your existing mortgage, refinancing adds another 3 years of payments to the loan.
Because you’re extending your loan, you should make sure that you’re saving enough each month to make up for the additional payments.
For example, I refinanced after two years of owning my home. The monthly savings in interest with the refinance is $186. Even though I am adding two more years of payments, I am paying $2,232 less each year ($186 x 12), which will save me money in the long run. The total amount that I will make in future mortgage payments is less with my refinance, even though I will pay for 2 years longer than my original mortgage.
The Bottom Line
Since we’re living in a free market, it’s usually impossible to “time” the market to get the best rate. So even if you happen to buy when rates have spiked, don’t despair. Remember that you will probably have the option to refinance later, if and when rates drop. And remember that your credit score affects what kind of rate you can get. (Read more about how your FICO affects your interest rate here.)
On the other hand, when you do lock in a 30-year mortgage rate, plan to keep it for the long term. Don’t agree to a rate unless you are 100% comfortable with the total monthly housing payment. Economic circumstances could limit your ability to refinance in the future, so it’s best to plan to keep the rate you have.
Finally: feel free to check out this no-cost, online home buyer workshop. This new tutorial is a comprehensive homeownership education course. CreditSmart® Homebuyer U offers six modules to promote education, homebuyer preparedness, and financial management.
Good luck, and contact me with any questions.
